The corporation is a business structure that is separate from its owners. In the eyes of the law, the corporation is a separate legal person with the same right and responsibilities as the ordinary individual.
Large companies of the world adopt this structure of business management. For instance, Google, Facebook, Apple and, Toyota have adopted corporations as business structures and operate across the globe.
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Detailed understanding (corporation)
Businesses need to adopt certain legal structures to operate in any region of the world. The business structure may include sole proprietor, limited liability Company, Limited Liability Partnership, and corporation. Usually, the companies with the larger business proportion adopt a corporation as a business structure to ensure effective run of business activities—the prime advantage of adopting a corporation as a business structure is a separate legal entity.
Further, ownership of a company is transferable from one person to others by buying and selling shares. In addition to this, perpetual succession is a distinguishing characteristic of a corporation that enables the continuity of business operations even after the death or bankruptcy of the owners. On the other hand, other forms of businesses cease after the death or insolvency of owners.
Corporations possess the same characteristics just like individuals, and some of these features are:
- Owns assets
- Makes borrowing arrangements
- Enters in contracts
- Makes payment of tax
- Hires employees
The corporate structure of a business comprises the Board of directors, officers, and shareholders. Shareholders are the individuals who legally own one or more shares in a company. The Board of directors and officers run a corporation on behalf of shareholders. They act as agents of shareholders and manage the day-to-day business activities of a company. Due to the limited liability, shareholders are not personally liable to pay the company’s debts.
However, lenders of the business do have the right to the assets owned by the corporation. It’s also important to note that assets are distributed to lenders in priority, and shareholders stand second in line.
In simple words, if the business is liquidated, the lenders/debt providers will be paid in full by selling the business’s assets. On the other hand, the shareholders will only be paid if some assets are left after making payments to the lenders.
Let’s discuss the advantages and disadvantages of the corporation.
Advantages of corporation
Corporations have various advantages including transferability of ownership, limited liability, perpetual existence, tax benefits, and better access to options for raising capital. Some of the benefits are elaborated here:
1) Limited Liability of corporation
The limited liability feature of corporations makes them an attractive option for investment. The shareholders are not liable to pay any amount out of their pockets in case of liquidation of a business. They can only lose the value of shareholding or already invested capital. That’s one of the prime reasons for the success of the stock market as an investment option.
2) Separate Entity
Corporations are provided the status of a separate legal entity. It means that a corporation can undertake contracts, own assets, sue or can be sued, involve in lending or borrowing activities, and sell assets in its name.
Further, it can be sued in a personal capacity and can sue some business/individual in a personal capacity.
3) Transfer of ownership
Ownership of a company is transferable from one person to another through the sale of shares. The shares of a listed company are usually traded on a stock exchange, and the buying and selling of shares transfer the rights associated with those shares. The life of a corporation has no limit because ownership can move across many generations of investors.
Hence, an owner/founder of a corporation can die, but the corporation status remains active.
4) Management expertise
The shareholders and management are usually not the same people in a corporation. For efficient business operations, competent managers can be hired to manage operational and strategic business activities. Further, expert staff can handle business operations better than owners who don’t have relevant business expertise.
Hence, it helps business managers to do the business even they do not understand fully.
5) Unlimited potential
Corporation grows more drastically than other types of business. The main reason behind this phenomenon is that it can easily fulfill its financial needs by issuing shares. Further, if the existing shareholders cannot fulfill the capital needs, then shares can be issued to new shareholders to raise finance.
Another important point to note is that banks and other financial institutions place more reliance on the corporation because corporations need to comply with more stringent regulations by the Government and the code of Corporate Governance. So, with perspective to the raising finance, corporation as business structure seems to be more desirable business structure.
6) Tax Benefits
Some of the corporations may face difficulty in the form of double taxation. Still, at the same time, tax benefits are also available in the form of different taxation rates for different income heads. The allowable tax expenses are subtracted from income to calculate the taxable income of an entity. Governments may also provide subsidies in the form of tax-free zones if businesses meet specific requirements.
So, the business has some more options to save profit if it operates as a corporation.
7) Easy availability of loans from Banks
The financial reports of listed corporations are publicly available to the general public. The banks and other stakeholders can assess the position of a company by analyzing its financial statements. So, it is easy for a corporation to take a loan from a bank by providing their financial statements. However, individuals may find it difficult to obtain a loan as it’s a riskier option for a bank to recover their amount in case of default.
Disadvantages of corporation
Corporations also face certain drawbacks. There are certain shortcomings in this type of business, and it may apply to both shareholders and corporations. Some of them are discussed below:
1) Conflicts between management and shareholders
The business is managed by people that are different from the owners of the corporation. So, there can be difficulty in this situation when management’s goals don’t align with that of shareholders. A conflict may arise between management and owners in such a situation. Most of the decisions of a corporation are made by the management rather than the actual owners of a business. So, there is a chance that management policies and the procedure are not in alignment with the vision of shareholders.
Further, management can manipulate the financial performance and involve in fraudulent financial activities. That’s why an audit of a company is a must practice for resolving such matters. Although, it has its limitations.
2) Double taxation problems with corporation
A corporation may face problems of double taxation which means that tax has to be paid at the company level and in the hands of shareholders. This is potentially a big problem as investors are discouraged due to these strict regulations.
Further, the introduction of global tax reform seems to limit the tax advantage due to internationalization.
3) Business Documentation and costs
The formation of a business is lengthy and full of procedural formalities compared to other businesses. Proper documentation and filing of the article of incorporation are necessary to establish a corporation. Legal formalities and extensive paperwork are essential that can be difficult and time-consuming.
Although capital requirements of corporations can be easily met via allotment of shares, the establishment of the corporation is still expensive. Further, the cost of auditors, non-executive Directors, and other regulatory aspects need to be met.
4) No confidentiality of accounts
Corporations have to publish their financial statements publicly (except in the case of private corporations). There is no secrecy of accounts as information is available to the public. Competitors can evaluate a company’s critical data from its published reports and may use that information for enhancing their business activities.
Corporation is a well-known form of legal business arrangement. Giant companies like Google, Apple, Facebook, and Toyota have adopted the corporation as a business structure.
There are multiple advantages of a corporation: limited liability, separate legal person, transfer of ownership, unlimited potential, and tax advantage due to geographical spread. Further, lenders place more reliance on the corporation as more information is available to them for investment-related risk assessment.
There are few drawbacks of forming a corporation that includes agency conflict between shareholders and management, higher cost of compliance in terms of audit & regulatory procedures, and impaired confidentiality.
Frequently asked questions for corporation
What’s the biggest advantage of a corporation?
The biggest advantage of the corporation is the separation of a legal obligation from business owners. If the business goes into liquidation, the shareholders have a shield against losses.
Why is equity considered costly than debt financing?
Equity financing is considered more costly than debt because of the tax advantage associated with debt financing. The interest paid on the debt financing is allowable for calculating taxable income. On the other hand, the dividend paid on the shares is not tax allowable. Additionally, the issue of equity leads to dilution in controls of existing shareholders.
How to calculate the cost of equity?
The cost of equity is calculated by using Capital Asset Pricing Model – CAPM. On the other hand, overall business valuation can be performed via Discounted Cash flow model.
What are the components of the cost of capital?
Debt and equity are the components of the cost of capital. The proportion of debt and equity is taken in the actual proportion, and the cost is applied to calculate the cost of capital.